ADB Abhijit Sen Gupta GDP Growth Model

QUARTERLY FORECASTING MODEL
FOR INDIA’S ECONOMIC GROWTH:

BAYESIAN VECTOR
AUTOREGRESSION APPROACH
Tara Iyer and Abhijit Sen Gupta
NO. 573 ADB ECONOMICS

March 2019 WORKING PAPER SERIES
ASIAN DEVELOPMENT BANK

ADB Economics Working Paper Series
Quarterly Forecasting Model for India's Economic Growth:

Bayesian Vector Autoregression Approach
Tara Iyer and Abhijit Sen Gupta Tara Iyer (tiyer.consultant@adb.org) is a consultant and
Abhijit Sen Gupta (asengupta@ad.org) is senior
economics officer of the India Resident Mission of the
No. 573 | March 2019 Asian Development Bank.
The authors would like to gratefully acknowledge the

valuable guidance and detailed comments received from
Lei Lei Song at various stages. The authors thank
Sabyasachi Mitra for very helpful feedback. The authors
also appreciate the comments of an anonymous reviewer.
All errors remain the authors’ responsibility.

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DOI: http://dx.doi.org/10.22617/WPS190056-2
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CONTENTS
TABLES AND FIGURES iv
ABSTRACT v%%
I. INTRODUCTION 1
II. MACROECONOMIC TRENDS IN INDIA 4
III. FRAMEWORK 11
A. Real and Monetary Variables 12
B. Structural Vector Autoregressions 14
C. Forecast Evaluation 15
IV. DATA 15
V. EMPIRICAL RESULTS 17
A. Univariate Autoregressive Integrated Moving Average Models 17
B. Bayesian Vector Autoregressions: Q1 2004–Q1 2017 Estimation Period 18
C. Bayesian Vector Autoregressions: Q1 2011–Q1 2017 Estimation Period 20
D. Vector Autoregression and Structural Vector Autoregression Forecasts 23
E. Extending the Validation Period 24
F. Inflation Forecasts 24
G. The Changing Dynamics of Gross Domestic Product Growth 25
VI. CONCLUSION 26
APPENDIX 28
REFERENCES 37
TABLES AND FIGURES
TABLES
1 Real Sector Groups in the Bayesian Vector Autoregressions 13

2 Monetary Sector Groups in the Bayesian Vector Autoregressions 13
3 Structural Vector Autoregression Models 14
4 Empirical Models 16
5 Top 10 Bayesian Vector Autoregression Forecasting Models of Gross Domestic Product 18
Growth (Q1 2004–Q1 2017 estimation period)
6 Composition of the Top 50 Gross Domestic Product Growth Forecasts 20
(Q1 2004–Q1 2017 estimation period)
8 Top 10 Bayesian Vector Autoregression Forecasting Models of Gross Domestic Product 22
9 Dynamic Bayesian Vector Autoregression and Autoregressive Integrated Moving Average 25
Forecasts of Consumer Price Index Inflation (Q1 2004–Q1 2017 estimation period)
A.1 Data Sources 28
A.2 Top 50 Bayesian Vector Autoregression Forecasting Models of Gross Domestic Product 30
A.4 Top 10 Vector Autoregression Forecasting Models of Gross Domestic Product Growth 33
A.5 Top 10 Vector Autoregression Forecasting Models of Gross Domestic Product Growth 33
A.6 Structural Vector Autoregression Forecasting Models of Gross Domestic Product Growth 34
A.7 Structural Vector Autoregression Forecasting Models of Gross Domestic Product Growth 34
A.8 Dynamic Bayesian Vector Autoregression and Autoregressive Integrated Moving Average 35
Forecasts of Consumer Price Index Inflation (Q1 2011–Q1 2017 estimation period)
FIGURES
1 Gross Domestic Product Growth 5

2 Decomposition of Gross Domestic Product Growth 5
3 Growth Rate of Key Components of Gross Domestic Product 6
4 Trade Integration 7
5 Export and Import Growth 7
6 Inflation 8
7 Repo and Reverse Repo Rates 9
8 Oil Inflation and Gross Domestic Product Growth 9
9 International Financial Integration 10
10 Portfolio Flows and Foreign Direct Investment 10
11 Effective Exchange Rates 10
12a Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018) 19
12b Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018): A Closer Look 19
13a Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018) 22
13b Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018): A Closer Look 23
14 5-Quarter Ahead Bayesian Vector Autoregression Forecast 24
15 6-Quarter Ahead Bayesian Vector Autoregression Forecast 24
ABSTRACT
This study develops a framework to forecast India’s gross domestic product growth on a quarterly
frequency from 2004 to 2018. The models, which are based on real and monetary sector descriptions
of the Indian economy, are estimated using Bayesian vector autoregression (BVAR) techniques. The
real sector groups of variables include domestic aggregate demand indicators and foreign variables,
while the monetary sector groups specify the underlying inflationary process in terms of the consumer
price index (CPI) versus the wholesale price index given India’s recent monetary policy regime switch
to CPI inflation targeting. The predictive ability of over 3,000 BVAR models is assessed through a set
of forecast evaluation statistics and compared with the forecasting accuracy of alternate econometric
models including unrestricted and structural VARs. Key findings include that capital flows to India and
CPI inflation have high informational content for India’s GDP growth. The results of this study provide
suggestive evidence that quarterly BVAR models of Indian growth have high predictive ability.
Keywords: Bayesian vector autoregressions, GDP growth, India, time series forecasting
JEL codes: C11, C32, C53, F43

I. INTRODUCTION
This study seeks to develop an appropriate forecasting model to predict India’s gross domestic product
(GDP) growth. It is well known that econometric forecasting has historically been an exercise fraught
with uncertainty. The challenge arises in designing a framework that accurately captures the underlying
economic structure and the precise variables that provide informational content on the indicators of
interest. The forecasting framework should be specific to the country in question, while noting that more
complex models with numerous macroeconomic interlinkages often do not perform as well as
parsimonious models. Additional econometric challenges arise in developing and emerging market
economies (EMEs) since the time series can be more volatile, and sometimes certain variables are
unavailable. Yet, precise forecasts are of utmost importance to various stakeholders including policy
makers and monetary authorities for whom successful policy decisions depend on accurate predictions.
This paper develops an econometric framework that is effective in predicting GDP growth in India.
We construct a quarterly forecasting framework employing key macroeconomic variables

based on economic theory on the real and monetary sectors in the economy. Bayesian vector
autoregression (BVAR) models have been known to generate reasonable forecasts (e.g., Giannone et
al. 2015) and address the curse of dimensionality that arises with unrestricted VARs. By specifying a
prior distribution for the parameters of the VAR model and using Bayes’ theorem, Bayesian inference
allows for more efficient estimates and forecasts without as much of a loss of degrees of freedom. We
corroborate the BVAR models in this study with structural vector autoregressions (SVARs), where
identification restrictions are imposed based on economic theory. VAR and autoregressive integrated
moving average (ARIMA) models of GDP growth are also estimated. We select the most effective
GDP growth forecasting model based on estimating and evaluating the predictive ability of several
multivariate econometric models that capture key macroeconomic linkages in the Indian economy.
In the BVARs, we specify four real sector models of GDP growth and three models that
describe monetary policy. These are discussed further in section III. The real sector variable groups are
based on aggregate demand indicators including public and private consumption, and external sector
variables such as foreign direct investment (FDI) and portfolio flows. We also assess the effects of the
exchange rate on growth since India is open to trade and financial flows. The monetary sector variable
groups are specified in terms of the underlying inflationary process. Noting that the Reserve Bank of
India (RBI) switched to consumer price index (CPI) inflation targeting in 2015 from a hitherto multiple
indicators approach where wholesale price index (WPI) inflation was a target, we test models specified
in the CPI as well as in the WPI using the repo rate as the monetary policy instrument. Given the
predominance of cash-based economic activity in India, we assess variants of these models with
money, and specify some BVARs only in narrow money. We further control for the effects of oil price
shocks and United States (US) monetary policy.
A key finding is that the BVAR models are able to predict the dynamics of GDP growth very well.
A large number of BVAR models are estimated over the first quarter of 2004 until the first quarter of
2017, with their out-of-sample forecast accuracy evaluated over the latest four quarters for which data is
available. The best BVAR forecasts are shown to closely track the data (Figures 8a and 8b in section V),
and outperform ARIMA, VAR, and SVAR models. The significant majority of BVAR models developed in
this paper outperform a random walk forecast, the conventional benchmark used in the literature. The
results from estimating the BVARs suggest that the models that perform the best take into account the
influence of global factors, such as FDI and portfolio flows, in driving GDP growth in India.
2 | ADB Economics Working Paper Series No. 573
The high predictive power of the BVARs holds robust to major shocks such as the global financial
crisis (GFC) and the Indian demonetization, structural changes including the monetary policy regime
switch from a multiple indicators approach to inflation targeting, revisions in the Indian national accounts
data, as well as several variations in the start and length of the estimation and validation periods. In the
BVARs, tighter prior distributions seem to allow for greater forecast accuracy than looser beliefs. Further,
spot oil prices and CPI inflation seem to have predictive content for GDP growth. Additional findings
include that the BVARs have good predictive power for CPI inflation as well, a useful finding from the
standpoint of the literature. Another finding from estimating the models over a historical time period is
that the variables relevant for predicting GDP growth seem to have changed over time, with trade
linkages more relevant in the early 2000s, and capital flows highly influential from 2005 onward.
Literature Review
The literature contains several forecasting studies for EMEs in general, and some previous papers on
India. For the most part, macroeconomic indicators in emerging markets are not found to be easy to
predict, with random walk models sometimes found to outperform more complex econometric
frameworks. Bayesian and factor-augmented VARs, however, seem to perform relatively well. Two
recent papers, Mandalinci (2017) and Duncan and Martinez-Garcia (2018), compare and summarize
the results of multivariate VAR-based forecasting models across several EMEs.
Mandalinci (2017) compares the forecasting performance of various time series specifications
for a panel of 10 EMEs from Q1 2001 to Q3 2014. The models include univariate as well as multivariate
VAR frameworks for inflation and GDP such as factor-augmented VARs (FAVAR), time-varying
parameter VARs (TVPVAR), and unobserved component stochastic volatility (UCSV) specifications.
They find that overall the UCSV model performs the best across countries (especially in Mexico and
Turkey) followed by the TVPVAR specification. During the peak of the GFC, however, the TVPVAR
performed better. For India, a time-varying parameter factor-augmented VAR (TFP-FAVAR) is found
to perform reasonably well along with the UCSV specification.
Duncan and Martinez-Garcia (2018) analyze the predictive ability of quarterly inflation
forecasting models over the years 1980–2016 for 14 EMEs. A variant of the random walk model is
generally found to be the best framework for predicting inflation. The authors contrast these results for
EMEs with those for advanced economies, where variants of the Philips curve specification have found
more success in forecasting inflation (evidence based on studies including Coibion and
Gorodnichenko 2015 and Kabukçuoğlu, and Martínez-García 2018). Apart from random walk types of
specifications for forecasting inflation, factor-augmented models also tend to perform relatively better.
While the studies above analyze the performance of forecasting models across a panel of
EMEs, we also review some papers that assess the predictive ability of models for individual countries.
Liu and Gupta (2007) develop a dynamic stochastic general equilibrium (DSGE) model to forecast
South African macroeconomic aggregates including gross national product and investment at a
quarterly frequency from 1970 to 2000. They compare the predictive ability of the DSGE model to a
range of VAR and BVAR models. They find that, in general, the DSGE model performs relatively poorly
and that BVAR specifications perform the best. Among the BVAR models, those with looser priors
outperform the others in terms of predicating consumption and investment, whereas the predictability
of gross national product improves with tighter Bayesian priors. In follow-up papers, Gupta and
Kabundi (2010, 2011), in forecasting key macroeconomic aggregates in South Africa, find that large-
Quarterly Forecasting Model for India's Economic Growth | 3
scale dynamic factor models (DFMs) and BVARS have better predictive ability than structural DSGE
models or reduced-form VAR specifications.
Altug and Cakmakli (2016) formulate an inflation forecasting model based on inflation
expectations measured using survey data for two EMEs—Brazil and Turkey. The baseline model treats
inflation as a random walk process with a seasonal component. Survey-based expectations are brought
into the model by assuming that survey and model-predicted expectations match each other save for a
random error. The model is estimated at a quarterly frequency from 2001 to 2014 to find that a
forecasting model augmented with survey-based expectations does no worse than a moving average
model in Brazil, and in Turkey has superior predictive ability. Öğünç et al. (2013) and Gunay (2018)
evaluate the forecasting properties of a range of models including BVARs and FAVARs in Turkey, to
find that factor models do not always have greater predictive power despite utilizing more data.
Öğünç et al. (2013) forecast inflation at a quarterly frequency for Turkey for a time period from
2001 onward using a variety of models including ARIMAs, VARs, BVARs, and FAVARs. They find that
forecast averaging works the best, in general, in terms of reducing prediction error. Gunay (2018)
analyzes the ability of different factor models to predict industrial production and inflation in Turkey at
a monthly frequency from 2009 onward. The model uses data on industrial production, trade, interest
and exchange rates, commodity prices, financial market indicators, and consumer and business
confidence. The predictive ability of factor models depends on their specification and the particular
data series used in generating the factor. Doğan and Midiliç (2016) employ more than 200 daily
financial series, including commodity prices and equity indices, to forecast and nowcast quarterly GDP
in Turkey using mixed data sampling techniques. The authors find that that the use of high-frequency
financial and macroeconomic data in predicting output leads to forecasting gains.
Figueiredo (2010) analyzes the ability of FAVAR models to predict inflation in Brazil at a monthly
frequency from 1995 to 2009, after the Real Plan stabilization program started in 1994. To construct the
factor model, they employ nearly 400 variables on prices, labor market indicators, aggregate and sectoral
output, interest rates, and other monetary and financial market indicators, and trade related indicators.
The study finds that using more factors does not necessarily increase predictive accuracy, and that the
relative performance of factor models improves with longer forecast horizons. Pincheira, Selaive, and
Nolazco (2017) develop a time series model to predict headline inflation in eight developing countries in
Latin America on a monthly basis from 1995 to 2017. The methodology developed focuses on whether
core inflation has any useful informational content in predicting headline inflation in a multivariate single-
equation regression model for CPI inflation. The findings indicate that core inflation generally improves
the predictive ability of the CPI model when the forecast horizon is less than 6 months.
Deryugina and Ponomarenko (2014) develop a BVAR model to forecast key Russian
Federation macroeconomic indicators at a quarterly frequency from 2000 to 2013. They include 14
variables in the framework ranging from real sector variables (GDP, consumption, investment) to
prices (including the CPI and GDP deflator), to monetary variables (including broad money and loans
to households), and external variables (including oil prices). They find that although the BVAR model
has relatively better predictive ability for real sector variables, it is outperformed by a random walk
specification in most cases. Porshakov et al. (2015) seek to predict Russian Federation GDP using a
DFM with many macroeconomic and financial variables. The paper focuses on short-term forecasts,
nowcasts, and backcasts on a quarterly basis. Findings include that while modeling fewer variables
produces adequate nowcasts and backcasts, the predictive accuracy of the DFM for one-quarter
ahead and two-quarter ahead GDP increases with the number of factors.
Some papers exist in the literature that seek to forecast industrial production or economic
growth in India. Aye, Dua, and Gupta (2015) evaluate the performance of 11 forecasting models for India.
They collect 15 monthly series from 1997 to 2011 on domestic and foreign industrial production, the WPI,
Treasury bill yields of different maturities, London interbank offered rates of different maturities, public
expenditure, money, and the exchange rate. While GDP growth is not included in the model, various
VARs, BVARs, and factor models are used to predict four variables—industrial production, inflation, the
exchange rate, and the 3-month Treasury bill rate. A key result from this paper is that while the models
generally outperform a random walk specification, the out-of-sample predictions from the suite of VARs,
BVARs, and factor models are far off from tracking the data. Benes et al. (2017) develop a semistructural
model for the purposes of generating policy simulations for the Indian economy but they do not provide
evaluations of the model’s ability to generate adequate forecasts.
In an earlier study on India, Biswas, Singh, and Sinha (2010) forecast industrial production,
WPI inflation, and narrow money using quarterly data from 1994 to 2007 using VAR and BVAR
approaches. The one-step ahead BVAR forecasts are able to reasonably track historical data, but
dynamic forecasts are not provided. Bhattacharya, Chakravarti, and Mundle (2018) use a factor-
augmented time-varying parameter regression approach to forecast India’s GDP growth. While the
model is able to capture historical trends in growth quite well, this is based on static forecasts similar to
Biswas, Singh, and Sinha (2010). Furthermore, the model is estimated at an annual frequency. The
present study makes two contributions to the literature. First, we are perhaps the first to use a Bayesian
VAR approach to forecast economic growth in India on a quarterly basis. We evaluate dynamic
forecasts, which are relevant to stakeholders, with our dataset extending until 2018. We compare the
BVAR forecasts to that of VARs, SVARs, and ARIMAs. Second, we develop a macroeconomic
framework that models the real and monetary sides of the Indian economy. This approach yields novel
insights into the predictive ability of various real and monetary theories of economic growth in India.
The rest of this paper is structured as follows. Section II provides an overview of some key
macroeconomic trends in India. Section III develops the BVAR forecasting framework and discusses
the real and monetary models that we specify of the Indian economy. Section IV discusses the data
used in the empirical analysis. Section V presents the empirical results and evaluates the predictive
ability of the models. Section VI concludes.
II. MACROECONOMIC TRENDS IN INDIA
India has emerged as one of the fastest-growing emerging economies, growing at an average rate of
7.6% during the last decade and a half (Figure 1). This paper tracks India’s growth process from Q1
2004 onward to build a quarterly model that captures the main determinants of economic growth.1
India’s GDP grew by an average of 5.5% between Q1 1997 and Q4 2003, primarily driven by domestic
demand comprising private consumption and investment (Figure 2). GDP growth surged between Q1
2004 and Q2 2008, with the average growth rate exceeding 9%, before growth declined during the
GFC. While private consumption and investment continued to remain key drivers of growth due to
significant domestic reforms, exports also became an important contributor owing to favorable
external factors, which included a surge of capital flows to emerging markets including India (for
further details, see World Bank 2018).
1
Quarterly data on Indian GDP is available from Q2 1996. Furthermore, all dates in this paper are in the Indian fiscal year
format (April 1 – March 31), so that, for instance, Q1 1996 refers to the April 1 – June 30 quarter.
Figure 1: Gross Domestic Product Growth
Source: Centre for Monitoring Indian Economy (CMIE) Economic Outlook Database (accessed 15 December 2018).
Figure 2: Decomposition of Gross Domestic Product Growth
Q = quarter.
India’s GDP growth has witnessed a lot of volatility in the subsequent period. GDP growth
slowed significantly in the wake of the GFC, with growth dropping to an average of 4.1% during Q3
2008 to Q3 2009. Growth was largely consumption led in this period with private and government
consumption accounting for a major part of the growth with the government providing a large fiscal
stimulus. Exports and investment remained virtually stagnant over this period. India recovered
relatively fast from the GFC and growth rebounded to average over 10% during Q4 2009 to Q2 2011
aided by a pickup in investment and exports. However, emerging policy and structural bottlenecks,
along with external factors becoming less benign, resulted in growth dropping to an average of 6.3%
during Q3 2011 to Q4 2014. Growth recovered somewhat to 8% in the period Q1 2015 to Q2 2016, as
India, being one of the largest crude oil importers, benefitted from a sharp drop in global oil prices
along with resolution of some of the bottlenecks. Cash shortages in the aftermath of demonetization,
firms incurring transitional costs post the introduction of the goods and services tax (GST) and a
recovery in global oil prices resulted in growth dipping down to 6.9% in the most recent period.2
Private consumption expenditure has remained the single largest component of GDP,
accounting between 52.2% and 65.7% of GDP. Along with government consumption, whose growth
has been much more volatile, over all consumption has accounted between 68.2% and 78.7% of GDP.
Investment growth has also been very volatile. Healthy growth in the period prior to the GFC led to
investment reaching nearly 40% of GDP. However, investment growth slowed down markedly since
then owing to structural and policy bottlenecks, heightened uncertainty and deteriorating business
confidence. While there has been some recovery in recent quarters, investment growth has lagged
GDP growth resulting in the investment-to-GDP ratio declining to 34.5% by Q1 2018.
Figure 3: Growth Rate of Key Components of Gross Domestic Product

(7-quarter moving average)
GDP = gross domestic product, Q = quarter.

2
On 8 November 2016, the government withdrew the legal tender status of INR500 and INR1,000 currency notes, which
accounted for 86% of the value of cash in circulation and introduced new INR500 and INR2,000 notes. The delay in the
printing of the new notes led to a cash shortage and temporarily strained economic activity. The GST was introduced from
1 July 2017, replacing a plethora of central, state, and interstate taxes with a single nationwide tax. Some uncertainty
related to the structure, rates, and exemptions had a transitional impact on business activity.
India has become more integrated with the global economy over the past few decades. India’s
trade integration, measured as a share of exports and imports to GDP, increased from around 20% of
GDP in the late 1990s to over 55% in mid-2008 (Figure 4). Much of the increase was witnessed between
2003 and 2008 when exports grew by 23.1% annually while imports grew by 30.2% (Figure 5). With the
slowdown in global trade since 2011, structural bottlenecks hampering the domestic manufacturing
sector and a decline in commodity prices, both exports and imports experienced growth that trailed GDP
growth, resulting in the ratio of trade to GDP dropping to around 40.6% in recent quarters.
Figure 4: dƌĂĚĞ/ŶƚĞŐƌĂƟŽŶ Figure 5: ǆƉŽƌƚĂŶĚ/ŵƉŽƌƚ'ƌŽǁƚŚ
GDP = gross domestic product. Q = quarter.

Source: World Bank. World Development Indicators (accessed Source: Lane and Milesi-Ferretti (2017).
15 December 2018).

Inflationary pressures impact GDP growth. In India, inflation is measured using a wide range of
indices. The two most commonly used indices to track inflation are the CPI and WPI. The WPI
measures the prices of goods at different stages in the production and distribution process while the
CPI measures the retail prices of goods and services that households consume. In India there are four
different types of CPI inflation depending upon the different segment of the population they focus on.
These include industrial worker, agricultural labor, rural labor, and urban nonmanual employees. Since
2011, the government started releasing data on a new measure of CPI known as Combined CPI, which
provides price indices separately for rural and urban population. This is a more representative measure
as it includes the service sector, which accounts for the largest share of India’s GDP. Both WPI and CPI
price indices are available at a monthly frequency. Finally, the GDP deflator is another index that can
be used to measure inflation. The GDP deflator is obtained by using different primary price indices,
which are used to deflate individual components of GDP valued at current prices to obtain volume
estimates. However, as pointed out in Patnaik, Shah, and Veronese (2011) in India, the GDP deflator is
mainly available at a quarterly frequency and for selected products.
Given the wider coverage and greater representation by the Combined CPI index, and the fact
that Combined CPI inflation has been selected as the official target under the Monetary Policy
Framework Agreement signed in February 2016, we focus on Combined CPI inflation in this paper.
However, data on Combined CPI inflation is available only from 2012. To overcome this, we follow RBI
(2014) and use the backcast data generated by using CPI-Industrial Worker (Base: 2001=100).
Figure 6: Inflation

There are fundamental differences between the WPI and Combined CPI, especially in the weights
of the various components. The share of food and beverages in the Combined CPI basket is 45.9%, nearly
double of the 24.4% weight accorded in the WPI basket. In contrast, fuel and light account for only 6.8% in
the Combined CPI while its share in the WPI is 13.2%. Finally, manufactured goods continue to dominate
the WPI with a share of 64.2% while goods and services account for 47.3% in the Combined CPI inflation.
As a result of these differences the CPI and WPI have moved in different directions (Figure 6). In the
immediate period before the GFC, both the WPI and CPI inflation witnessed an increase, although the
extent of increase in the case of WPI inflation was much higher. This was primarily due to a rise in global fuel
and food prices, which also impacted domestic food prices. WPI inflation fell sharply during the GFC since
iron and steel prices contracted by 20% and fuel prices contracted by 10%. The dip lasted for a few months
only as commodity prices recovered shortly. CPI inflation continued to increase driven by domestic factors
such as high procurement prices and rising demand for high-value food products (Bajpai 2011,
Bhattacharya and Sen Gupta 2017). CPI inflation, despite dipping from the peak reached in late 2009
remained at elevated levels until late 2013, mainly due to high food prices even though WPI inflation dipped
on account of moderation in commodity prices.
A combination of factors caused both the WPI and the CPI inflation to decline since 2014. These
include food inflation remaining low due to improved food management, modest increase in
procurement prices and benign global prices. A sharp drop in global commodity prices including crude oil
prices and the introduction of inflation targeting led to a moderation in core and fuel inflation. Again, the
decline in the WPI inflation was more pronounced due to the sharp drop in crude oil prices, impacting
fuel inflation, which had a higher weight in the WPI basket. Shocks such as demonetization also
contributed to low inflation during this period as it temporarily disrupted economic activity. Inflation
started inching up from mid-2017 as growth picked up and crude oil prices rebounded sharply.
Quarterly
Q Foreecasting Modeel for India's Ecconomic Grow
wth | 9
The
T monetaryy policy archittecture has also a undergon ne significantt changes sinnce the late 1990s.
In 1998, the RBI adoptted a “multip ple indicators approach,” wwherein varioous macroeco onomic indicators,
including various ratess of return, exxchange rate,, credit exten
nded by finanncial institutio
ons, fiscal possition,
trade andd capital flowws, and inflattion rate werre analyzed tto underline monetary po olicy perspecctives.
This multtiple indicato
or approach was w further augmented
a w
with forward looking indiccators drawn from
various su
urveys. To im
mprove the monetary
m policcy operating framework, a Liquidity A Adjustment Faacility
was set up
u in 2000 under which h the RBI usses the repo and the revverse repo raates as key p policy
instrumen nts providingg a corridor for
f the overn night money market ratess (Figure 7). The width o of the
corridor has
h differed over
o time dep pending on thhe macroecon nomic needs of the econo omy.
Oil
O prices and d economic activity
a in Inddia appear to h an R2 of 0.4
o be fairly corrrelated with 43 for
the entiree period i.e., Q1
Q 2004 to Q1 Q 2018 (Figu ure 8). The o oil price indexx is modeled in this paper as an
exogenou us variable. The
T correlatio on is seen to be significan ntly higher in
n the period eencompassin ng the
2
GFC until before the oil price collaapse in 2014 with the R rising to 0.69 9 during Q1 22008 to Q4 2013.
This highh positive correlation is likely spuriou us and was p possibly driveen by comm mon global sh hocks
including the GFC, the subsequen nt recovery, and a the eurozzone crisis. In recent yeaars, the correlation
between oil prices and d GDP has ve eered toward d the negativ e side (the correlation fro om Q1 2014 to Q1
2018 is –0.32), probably because of fewer com mmon global shocks. Furtthermore, an increase in gglobal
oil prices results in a negative terms of trade sho ock, given Ind dia’s high impport dependeence, resultin
ng in a
decline inn GDP growth as resource es that could d be domesticcally invested d or consumed are transfferred
outside. Similarly,
S a de
ecline in globaal oil prices iss likely to ben
nefit economiic growth.
Figure 7: Repo and Reverse R epo Rates Figurre 8: Oil Infl ation and G r oss Domesttic
oduct Growt h
Pro
Source: Ce
entre for Monitorin
ng Indian Econom
my (CMIE) Econom
mic GDP = ggross domestic pro
oduct.
Outlook Database (accessed 15 December 20 018). Source: C
Centre for Monito
oring Indian Econo
omy (CMIE)
Econom ic Outlook Datab base (accessed 15 December 2018)..

n line with itss rising trade openness, In
In ndia has also become sign nificantly inteegrated with gglobal
capital markets. Accorrding to Lane e and Milesi-F
Ferretti (20177), India’s integration withh the global ccapital
markets, measured as the ratio of foreign
f assets and foreign n liabilities to GDP increassed from lesss than
40% in thhe late 1990s to over 75% in recent yeaars (Figure 9)). Much of th his increase h
has been drivven by
n portfolio and FDI flows, which wass aided by In
a surge in ndia undertaking a gradeed liberalization of
capital flo
ows (Figure 10). Equity flo ows were givven preferencce over debt flows, and w within equity flows
FDI was preferred compared to portfolio flows. Portfolio flows are seen to be generally more volatile
than FDI. Portfolio flows played a role in increasing growth prior to the GFC but reversed as growth
slowed down in the aftermath. Capital flows to India slowed again during the taper tantrum of 2013,
when US Treasury yields surged as the Federal Reserve slowed down its quantitative easing program.
Figure 9: International Financial Figure 10: Portfolio Flows and Foreign Direct
Integration Investment
FDI = foreign direct investment, GDP = gross domestic product.

GDP = gross domestic product. Source: Centre for Monitoring Indian Economy (CMIE) Economic
Source: Lane and Milesi-Ferretti (2017). Outlook Database (accessed 15 December 2018).

Given India’s rising integration with global markets, both on the current and financial account, the
exchange rate has emerged as a key variable for economic growth. Figure 11 plots the trade-weighted nominal
effective exchange rate (NEER) and real effective exchange rate (REER). The NEER is a summary measure of
Figure 11: Effective Exchange Rates

the rate at which the rupee trades against a basket of currencies of 36 of India’s trading partners. The REER
is the nominal exchange rate adjusted for price differentials between India and these trading partners.
Since the GFC, NEER, and REER have followed divergent path (Figure 10). The NEER has
depreciated over time indicating that the Indian rupee has weakened against these currencies. However,
despite the weakening in nominal terms, the rupee has appreciated in real terms against this basket of
currencies since inflation in India continue to remain higher compared to most trading partners.

III. FRAMEWORK
In this section, we outline the framework and methods we use for the purposes of forecasting GDP
growth. Let ܻ௧ be a vector of ܰ endogenous variables
ܻ௧ ൌ ߤ ൅ ߚଵ ܻ௧ିଵ ൅ ‫ ڮ‬൅ ߚ௞ ܻ௧ି௞ ൅ ‫ݑ‬௧
where ρ is a vector of constant terms, ߚଵ ǡ ǥ ǡ ߚ௞ are coefficient matrices, and ‫ݑ‬௧ is an error component
that is normally distributed with a mean set of zeroes and covariance matrix ߑ, ‫ݑ‬௧ ̱ܰሺͲǡ σሻ. If we
consider an unrestricted VAR model for ܻ௧ , then the distribution of the parameter vector ߚ ‫ؠ‬
‫ܿ݁ݒ‬ሺሾρǡ ߚଵ ǡ ǥ ǡ ߚ௞ ሿᇱ ሻ can be computed through ordinary least squares. An essential part of the
macroeconomic toolkit, VARs capture the dynamic interdependencies among variables.
An unrestricted VAR allows the data to “speak” by imposing minimal assumptions on the data and
removing any constraints arising from economic theory. One drawback, however, is that the estimates are
inefficient if the VAR is overparameterized. Increasing the number of parameters and lags in a VAR can lead
to an exponential reduction in degrees of freedom. Overparameterization, besides inducing inefficient VAR
estimates, can also lead to large forecast errors (Aye, Dua, and Gupta 2015). The BVAR approach,
proposed in Litterman (1986), provides a solution to the VAR problem of overparameterization.
Consider the following conditional prior distribution of the VAR coefficients
ߚȁߑ̱ܰሺܾǡ ߑ۪ȳɉሻ
where the vector ܾ is the prior mean of the coefficients of each equation, ߑ۪ȳɉ is the covariance
matrix with ɉ as a scalar parameter governing the tightness of the prior distribution and ȳ as a matrix of
known weights, and the vector of hyperparameters, ߦ, determines the properties of the specified prior
distribution. The prior distribution characterizes the uncertainty associated with estimating the
parameters of the model before observing the variables. The BVAR parameters are random variables
with probability distributions in contrast to the VAR model, where the parameters are not stochastic.
The posterior distribution of the parameter vector, ߚȁߑǡ ‫ݕ‬, derived by combining the prior distribution
with the likelihood function, is normally distributed in many cases and given by
ߚȁߑǡ ‫̱ݕ‬ሺߚመ ሺߦሻǡ ܸ෠ ሺߦሻ
ߚመ ሺߣሻ ‫ܿ݁ݒ ؠ‬ሺ‫ܤ‬෠ሺߦሻሻ
‫ܤ‬෠ሺߦሻ ‫ ؠ‬ሺܺ ᇱ ܺ ൅ ሺߗߦሻିଵ ሻିଵ ሺܺ ᇱ ܻ ൅ ሺߗߣሻିଵ ߭ሻ
ܸ෠ ሺߦሻ ‫۪ߑ ؠ‬ሺܺ ᇱ ܺ ൅ ሺߗߣሻିଵ ሻିଵ

ᇱ ᇱ
where ܻ ‫ ؠ‬ሾܻ௞ାଵ ǡ ǥ ǡ ்ܻ ሿԢ, ܺ ‫ ؠ‬ሾܺ௞ାଵ ǡ ǥ ǡ ்ܺ ሿԢ, ܺ௧ ‫ ؠ‬ሾͳǡ ܻ௧ିଵ ǡ ǥ ǡ ܻ௧ି௞ ሿԢ, and ɓ is a matrix whose rows
correspond to the prior mean of the coefficients of each equation (see Giannone, Lenza, and Primiceri
[2015] for further details). The posterior distribution reflects that the prior distribution is updated
based on Bayes’ Theorem using the likelihood function, which represents the information contained in
the data about the parameters of the VAR model. Using maximum likelihood estimation, we employ
two commonly used conjugate prior distributions for which it is possible to derive analytical
expressions for the posterior distributions: the Minnesota prior and the normal-Wishart prior.
The Minnesota prior on ߚ is normally distributed conditional on the variance–covariance

matrix, σ, of error terms. This matrix is estimated by estimating the complete variance–covariance
matrix implied by the VAR, with a degrees of freedom correction. There are four main
hyperparameters in the Minnesota prior distribution: ߣǡ ρǡ ߛǡ ߪ. ߣ, perhaps the most important
hyperparameter, controls the prior standard deviation of the parameters and should be set closer to 0
for a tighter prior distribution. We vary ߣ between 0.1 and 0.5 to assess the forecasting accuracy of a
more restrictive versus looser prior distribution. ρ, the prior on the first-order autoregressive
coefficient, is typically set at or close to 1 if the model is specified in levels to take into account
persistence in the time series, and at 0 if the data in the model is in growth rates and stationary. We set
ρ at 0. ߛ, a cross-variable specific variance parameter that lies between 0 and 1 (lower values reduce or
turn off the coefficients of cross-lag variables), is set at 0.99 to allow cross-lag variables to play a
greater role in the estimation process. ߪ influences the rate at which the coefficients on higher-order
lags are shrunk toward 0, and we set it at 1 for no lag decay.
We also estimate the BVARs based on a normal-Wishart prior distribution for the parameters.
While the Minnesota prior does not take into account any uncertainty in the estimation of the
variance-covariance matrix of error terms, σ, the normal-Wishart prior models this uncertainty by
estimating the complete variance-covariance matrix with Bayesian methods. This yields a posterior
distribution for the parameters that is the product of normal and Wishart distributions. For further
details on the Minnesota and normal distributions, see Miranda-Agrippino and Ricco (2018). The prior
distribution for the estimation of the normal-Wishart matrix σ is set to depend on two
hyperparameters, ߫ and ȣ, where ɑrepresents the prior degrees of freedom and ȣ is an identity matrix.
Two hyperparameters govern the prior distribution of the parameter vector: ߣ and ρ. These have the
same interpretations as with the Minnesota prior. ρ is set at 0 as the model is specified in growth rates,
and we vary the hyperparameter, ߣ, between 0.1 and 0.5 to assess how the tightness of the prior
distribution influences forecasting accuracy.
A. Real and Monetary Variables
Each BVAR model in this study includes variables from the real and monetary sectors. We specify four
real models of GDP growth and three models that describe the evolution of monetary policy. The first
real sector group of variables, which follows in the Keynesian tradition, allows output to be determined by
the traditional drivers of aggregate demand: government spending, private consumption, investment, and
the trade balance. Termed the Keynesian Demand (KD) model, we empirically assess several variants of
this, and the other three models as detailed in the next section. The second variable group, which we
term the Exchange Rate Consumption (EC) model, accounts for the effects on growth of the dynamic
interlinkages between domestic consumption, the major component of GDP, and international relative
prices (captured through the trade-weighted exchange rate). Since exchange rate volatility impacts
consumption patterns in developing countries that depend on traded goods (e.g., Iyer 2016, Cravino and
Levchenko 2017) and since the effects on GDP of domestic consumption is typically reinforced by
corresponding fluctuations in international relative prices in open economies, it is interesting to test

whether the consumption–exchange rate nexus can explain the dynamics of output growth.
The third and fourth real sector groups of variables assess the importance of international
financial integration and capital flows for predicting economic activity in India. FDI and portfolio
inflows can enhance growth by reducing credit constraints in developing countries, augmenting
investment resources, increasing capital allocation and efficiency, enhancing domestic finance sectors,
and providing beneficial learning effects through technology transfer (e.g., Kawai and Takagi 2008,
Hannan 2018). Capital inflows can also adversely impact growth by increasing the possibility of sudden
stops in international lending and causing resources to transfer from tradable to slower-growing
nontradable sectors (e.g., Calvo and Reinhart 2000, Gourinchas and Obstfeld 2012, Reis 2013). The
Global Factors (GF) model assesses whether international financial integration and capital flows
influence GDP growth in India. Finally, the Fiscal External Flows (FEF) model examines whether the
confluence of government outlays and international investment has predictive power for economic
growth. Table 1 summarizes the real sector models of growth.
Table 1: Real Sector Groups in the Bayesian Vector Autoregressions
Real Sector Groups Variables

Keynesian Demand (KD) GDP, government spending, private consumption, investment, net exports
Exchange Rate Consumption (EC) GDP, effective exchange rate, government spending, private consumption
Global Factors (GF) GDP, portfolio flows, FDI flows
Fiscal External Flows (FEF) GDP, government spending, portfolio flows, FDI flows
FDI = foreign direct investment, GDP = gross domestic product.
Source: Authors’ compilation.

We specify the monetary theories in terms of the underlying inflationary process. The RBI
institutionalized a “multiple indicators” approach from the early 2000s, where there was no explicit
intermediate target. A variety of economic indicators were targeted, and the particular measure of inflation
was based on the WPI. With the signing of the Monetary Policy Framework Agreement in 2015, a regime of
flexible inflation targeting was formally adopted with CPI inflation as the target. The repo rate has been the
primary instrument to implement monetary policy since the Liquidity Adjustment Facility was set up in
2000. We set up models with CPI inflation and the repo rate, and WPI inflation and the repo rate. Since
India is predominantly a cash-based economy with a high share of informal market transactions, we test
variants of these models with money (M1) included in the spirit of the quantity theory of money. We finally
assess a model with only money to see whether changes in the monetary base has an impact on output due
to capacity constraints in the short run. These monetary theories are summarized in Table 2.
Table 2: Monetary Sector Groups in the Bayesian Vector Autoregressions
Inflationary Process Variables

CPI Inflation CPI and repo rate (plus a version with money)
WPI Inflation WPI and repo rate (plus a version with money)
Money Monetary base (narrow money)
CPI = consumer price index, WPI = wholesale price index.
B. Structural Vector Autoregressions
We pair the Bayesian analysis with SVARs. SVARs are based on an underlying economic structure
specified by the researcher. The SVAR disturbance terms are serially uncorrelated, achieved by placing
restrictions on the contemporaneous correlations in an unrestricted VAR. The SVAR residuals, ߝ௧ , and
the reduced-form errors, ‫ݑ‬௧ , are related through
ߝ௧ ൌ ‫ݑܤ‬௧
where we impose identification restrictions on the parameters in the matrix ‫ܤ‬. In this study, we work
with a 4-variable VAR in GDP, inflation (WPI or CPI), money, and the repo rate. We include the spot
oil price index and the Federal Funds rate as exogenous variables, assuming that the former is an
exogenous global shock and the latter affects global business cycles (Rey 2015).
The identification scheme assumes that domestic monetary policy shocks do not affect output
and inflation within the same quarter. Inflation reacts to output with a lag. The equation for inflation
can be interpreted as an aggregate supply equation, and that for output as an aggregate demand
equation. The equation for money demand can be interpreted as being derived from the quantity
theory of money, ‫ ܸܯ‬ൌ ܻܲ. The repo rate is ordered last, as monetary policy is set after observing the
current values of money, output, and inflation. The recursive identification scheme is given below.
௜௡௙ ௜௡௙
‫ߝ ۍ‬௧ ‫ې‬ ܾଵଵ Ͳ Ͳ Ͳ ‫ݑ ۍ‬௧ ‫ې‬
‫ߝێ‬௧௚ௗ௣ ‫ۑ‬ ܾଶଵ ܾଶଶ Ͳ Ͳ ‫ݑێ‬௧௚ௗ௣ ‫ۑ‬
‫ ێ‬௠ଵ ‫ ۑ‬ൌ ൦ܾଷଵ ܾଷଶ ܾଷଷ
൪
Ͳ ‫ݑ ێ‬௠ଵ ‫ۑ‬
‫ߝ ێ‬௥௘௣
௧ ‫ۑ‬
ܾସଵ ܾସଶ ܾସଷ ܾସସ ‫ ێ‬௥௘௣ ‫ۑ‬
௧
‫ߝ ۏ‬௧ ‫ے‬ ‫ݑ ۏ‬௧ ‫ے‬
We also assess variants of the baseline identification scheme to run four unique
identification schemes, and 16 SVARs totally. The baseline SVAR is specified without exogenous
variables, and three more sets are specified using as exogenous controls the spot oil price index, the
Federal Funds rate, and oil prices and the Federal Funds rate together. The variables are specified in
stationary terms (year-on-year growth rates), where we denote GDP by gdp, CPI or WPI inflation by
cpi_inf or wpi_inf, narrow money by m1, and the repo rate by rep, the oil price index by oil, and the
Federal Funds rate by ff. The identification restrictions for the four models without exogenous
variables are found below in Table 3.
Table 3: Structural Vector Autoregression Models
Model 1 {cpi_inf, gdp, m1, rep}

Model 2 {cpi_inf, gdp, rep}
Model 3 {wpi_inf, gdp, m1, rep}
Model 4 {wpi_inf, gdp, rep}
CPI_inf = consumer price index inflation, GDP = gross domestic
product, m1 = narrow money, rep = repo rate, WPI_inf = wholesale price
index inflation.
C. Forecast Evaluation
Each model’s predictive ability is evaluated by splitting the sample into two portions—the estimation
period and the validation period. The estimation period consists of observations ሾܶ଴ ǡ ܰሿ. In the
estimation period, each model is estimated and used to generate forecasts for ܰ ൅ ݄, where
݄ ൌ ͳǡʹǡ ǥ ǡ ܶଵ is the forecast horizon. In the validation period, consisting of observations ሾܰ ൅ ͳǡ ܶଵ ],
we evaluate the out-of-sample predictive accuracy of different models: BVARs, SVARs, VARs, and
ARIMAs. To evaluate each forecast, the root mean squared forecast error (RMSFE) of each model is
analyzed, where
ͳ ்భ
ܴ‫ ܧܨܵܯ‬ൌ σ ሺ߭ ሻଶ
ܶଵ ௛ୀଵ ௧ା௛ȁ௧
for ߭௧ as any model’s forecast error. The multivariate model forecasts are compared to the forecast
from a random walk as standard in the literature. For a model to beat the random walk, the RMSFE of
that model relative to the random walk, or the relative RMSFE, is required to be lower than 1. Along with
the RMSFE of each model, we also provide the mean absolute forecast error, and the Theil U inequality
coefficient which lies between 0 and 1 (values closer to 0 indicate greater forecasting accuracy).

IV. DATA
We specify the models based on time series of a quarterly frequency. The dataset extends from the
first quarter of 2000 until the latest available time period, which, at the time of writing, is the first
quarter of 2018. The two main estimation samples used in this study to generate four-quarter ahead
out-of-sample forecasts begin in Q1 2004 and Q1 2011, with both ending in Q1 2017. We also
investigate the changing dynamics of GDP growth by analyzing the four-quarter ahead predictions
from an earlier estimation sample extending from Q1 2000 to Q1 2006. Of note is that the fiscal
year in India begins on April 1 and ends on March 31 of the following year. The first quarter of each
year in our dataset therefore extends from April until June, and the last quarter extends from
January until March. We draw the variables from several databases including the Indian Ministry of
Statistics and Programme Implementation, the RBI, and the Federal Reserve Economic Database
maintained by the Federal Reserve Bank of St. Louis. A complete description of data sources is
provided in Table A.1 in the Appendix.
The data are in constant price terms with base year 2011–2012. A few years ago, the Central
Statistics Office released a new series of national accounts in 2011–2012 prices. This series was
rebased from the previously used 2004–2005 national accounts series and adjusted methodologically
to take into account the changing nature of economic activity over time. For further details on the
2011–2012 price series, please see NSC (2018). Since our dataset tracks back until 2000 with some
series specified in 2004–2005 prices, we splice the data so that all series are in constant 2011–2012
prices. For the CPI, since these data are only available from the fourth quarter of 2010, we backcast the
series using the reweighted industrial CPI. For the NEER and the REER, we use the 36-currency trade-
weighted indices from 2004 onward. Since these variables are only available from the first quarter of
2004 we splice the 36-currency indices with the reweighted 6-currency indices from 2000 to 2004.
We test the time series for stationarity using the augmented Dickey–Fuller and Phillips–Perron
unit root tests. The data series in levels are found to be nonstationary, and since we are interested in a
stationary forecasting model, we transform the variables into year-on-year growth rates to eliminate
unit roots. Once transformed, the variables in differences are stationary. As discussed in section III, we
empirically assess 14 real models and seven monetary theories of Indian growth in the data. We control
for oil price shocks and the effects of US monetary policy by including oil prices and the Federal Funds
rate as exogenous variables. The seven monetary models can be classified into three broad categories
as in Table 2: in CPI inflation, WPI inflation, and the monetary base. We test variants of these model
using the repo rate as the instrument of monetary policy, and accounting for money given the
predominantly cash-based nature of economic activity in India.
Table 4: Empirical Models
Real Variables Monetary Variables

GF GF1: GDP, FDI/GDP Model 1 CPI, repo rate
GF2: GDP, portfolio flows/GDP Model 2 CPI, money
GF3: GDP, FDI/GDP, portfolio flows/GDP Model 3 CPI, repo rate, money
EC EC1: GDP, NEER, private consumption, government spending Model 4 WPI, repo rate
EC2: GDP, REER, private consumption, government spending Model 5 WPI, money
EC3: GDP, NEER, government spending Model 6 WPI, repo rate, money
EC4: GDP, REER, government spending Model 7 Money
FEF FEF1: GDP, government spending, FDI/GDP
FEF2: GDP, government spending, portfolio flows/GDP Exogenous Variables
FEF3: GDP, government spending, FDI/GDP, portfolio flows/ GDP Spot oil price
KD KD1: GDP, private consumption, government spending, investment Federal Funds rate
KD2: GDP, private consumption, government spending, investment, net Spot oil price, Federal
exports Funds rate
KD3: GDP, government spending, investment
KD4: GDP, government spending, investment, net exports
CPI = consumer price index, EC = exchange rate consumption, FDI = foreign direct investment, FEF = fiscal external flows, GDP = gross
domestic product, GF = global factors, KD = Keynesian demand, NEER = nominal effective exchange rate, REER = real effective exchange
rate, WPI = wholesale price index.

The endogenous variables in the real and monetary models, along with the exogenous control
variables, are detailed in Table 4 above. The 14 groups of real variables can be classified into four broad
categories as in Table 1. These four economic theories of the real side of the economy examine the
influence of domestic and external factors in predicting GDP growth. The KD model tests whether
aggregate demand indicators matter for predicting GDP growth. The EC model accounts for the
importance of public and private expenditure in economic activity, and the role of international relative
prices in influencing domestic consumption and growth. The GF model assesses whether international
financial integration and capital flows influence output growth. Finally, the FEF model tests whether
the confluence of fiscal activity and cross-border capital flows matter for forecasting growth.
V. EMPIRICAL RESULTS
We estimate the forecasting models over two main samples. In the first estimation, the sample period
begins in the first quarter of 2004. This is around the time when GDP growth in India began to
accelerate, and India started becoming more integrated with the global economy. For robustness, we
also vary the start of the first estimation period to the first quarters of 2005 and 2006 for robustness
checks. In the second estimation, the sample period begins in the first quarter of 2011. While in the first
estimation the sample period includes the GFC and 2010 eurozone debt crisis, the second estimation
period excludes these. It is useful to have a second estimation period as several major structural
changes in India have taken place over the past few years including the shift to an inflation targeting
framework from a multiple indicators approach, demonetization of high currency notes, and the
introduction of the GST. Moreover, as shown in Figure 2, the drivers of growth have varied markedly
over time so using results from a more recent estimation period would provide additional insights. The
start of the second estimation period also corresponds to the time when the Central Statistics Office
revised and rebased the Indian national accounts data.
Both estimation periods end in the first quarter of 2017, with the forecast horizon set to be four
quarters ahead. We are interested in dynamic forecasts, where the previously forecasted values are
used to compute future predictions. In contrast, static forecasts use actual data to compute one-step
ahead predictions. Since the dynamic approach significantly increases forecast errors relative to the
static approach, the former method is a more rigorous test of whether a model has adequate predictive
power. We assess the predictive ability of univariate ARIMA models before turning to the richer
multivariate frameworks fitted through SVARs and BVARs. The validation period, over which the
predictive ability of the models is tested, extends from the second quarter of 2017 until the first quarter
of 2018. The forecasting power of different models is assessed using the RMSFE statistic. As
conventional in the literature, we compare the RMSFE of various models with that of a benchmark
random walk growth forecast. We also compare the out-of-sample accuracy of the BVAR and SVAR
forecasts to that of unrestricted VARs.
A. Univariate Autoregressive Integrated Moving Average Models
As a first step before the Bayesian multivariate approach, we follow the Box–Jenkins procedure (Box et
al. 2015) for selecting the best univariate ARIMA forecasting model. The GDP series is first made
stationary by taking its year-on-year growth rate. We then examine its autocorrelation and partial
autocorrelation functions to pick a preliminary ARIMA model for each estimation period. If the
estimated coefficients are not significant, or if the residuals are not white noise, we respecify the
model. Evidence of white noise is checked through autocorrelation and partial autocorrelation plots of
the residuals, as well as a portmanteau Box–Pierce test with the null hypothesis that the residuals are
white noise. Through this iterative process, we develop the optimal ARIMA models for each of the two
estimation periods. The forecasting power of these univariate models is compared to a random walk
forecast. The results suggest that for the estimation period starting in Q1 2004, a univariate model of
growth with 2 autoregressive (AR) terms and 1 moving-average (MA) term yields a relative RMSFE
(RRMSFE) of 0.11, and for the estimation period starting in Q1 2011, a univariate model of growth with
3 AR terms and 2 MA term yields an RRMSFE of 0.26. While the univariate specifications compare
favorably with the random walk benchmark (the RRMSFEs are well below 1), these models are much
further off from tracking Indian growth dynamics than the BVARs, as discussed next.
B. Bayesian Vector Autoregressions: Q1 2004–Q1 2017 Estimation Period
We use a Bayesian approach to estimate the multivariate models. We estimate each of the seven
monetary models independently before repeating the exercise with the 14 real models and three sets
of exogenous driving factors—(i) oil prices, (ii) the Federal Funds rate, and (iii) oil prices and the
Federal Funds rate. We run each BVAR with looser prior beliefs on the parameters (ߣ ൌ ͲǤͷ) as well as
with tighter priors (ߣ ൌ ͲǤͳ). This accords with the literature, where hyperparameters for the optimal
forecast are typically chosen based on the predictive ability of alternate Bayesian specifications. While
tighter priors can limit the data from “speaking” as much, overfitting may be a concern with looser
beliefs. We use the Minnesota and normal-Wishart prior distributions. For the Minnesota distribution,
the initial residual covariance matrix is estimated through a VAR with a degrees of freedom correction.
Overall, as detailed in Table 4, we fit 420 unique BVAR models of GDP growth based on the
real and monetary approaches. These include all the combinations of 15 real sector groups (the 14 real
models outlined in Table 4 plus a baseline real model specified only in GDP), 7 monetary models, and
4 sets of exogenous variables (oil, Fed Funds, oil and Fed Funds, no controls). Each model is estimated
with four sets of priors to make for a total of 1,680 BVAR models for each estimation period. We also
test the significance of recent structural changes to monetary policy—the adoption of inflation
targeting in the first quarter of 2015 and the demonetization shock in the third quarter of 2016.
Table 5 displays the top 10 BVAR forecasting models with the corresponding RRMSFEs, root
mean absolute forecast errors (RMAFEs) or the MAFE relative to the random walk, and the Theil U
coefficient. Of note is that these models are able to track the data very closely in the out-of-sample
dynamic forecasts, shown in Figure 12a and zoomed in further in Figure 12b. The specifications hold
robust when we vary the start of the estimation period to a year and 2 years ahead. The monetary
policy specification with CPI inflation as the target and the repo rate as the instrument comprises 70%
of the top 10 forecasting models. Most of these models are also based on the normal-Wishart tight
prior. We also check whether models other than the top 10 are able to accurately predict GDP growth.
We find that several BVAR models are able to generate very good forecasts. The top 50 models with
corresponding forecast evaluation statistics can be found in Table A.2 in the Appendix.
Table 5: Top 10 Bayesian Vector Autoregression Forecasting Models of

Gross Domestic Product Growth (Q1 2004–Q1 2017 estimation period)
Rank Real Monetary Exo Prior RRMFSE RMAFE Theil U

1 GF2 CPI, REP OILS Norm Tight 0.011 0.008 0.005
2 FEF2 CPI, REP OILS Norm Tight 0.011 0.009 0.006
3 KD4 CPI, REP OILS Norm Tight 0.011 0.011 0.006
4 … CPI, REP OILS Norm Tight 0.012 0.008 0.006
5 KD4 CPI, REP … Minn Loose 0.013 0.011 0.006
7 EC3 WPI, M1 … Norm Loose 0.013 0.011 0.007
8 FEF1 WPI, REP OILS, FF Minn Loose 0.013 0.011 0.007
10 EC1 WPI, M1, REP OILS, FF Norm Loose 0.014 0.013 0.007
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal funds, GF = global factors,
KD = Keynesian demand, M1 = money, Q = quarter, REP = repo rate, RMAFE = root mean absolute forecast error, RRMFSE =
relative root mean squared forecast error, WPI = wholesale price index.
Source: Authors’ calculations.
Figure 12a: Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018)

CPI = consumer price index, EC = exchange rate consumption, FDI = foreign direct investment, FEF = fiscal external flows, FF = Federal
funds, GDP = gross domestic product, GF = global factors, KD = Keynesian demand, M1 = narrow money, NEER = nominal effective
exchange rate, Q = quarter, REER = real effective exchange rate, REP = repo rate, WPI = wholesale price index.
Note: Q1 2004–Q1 2017 is the estimation period.
Figure 12b: Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018):
A Closer Look

CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal funds, GDP = gross domestic
product, GF = global factors, KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo rate, WPI = wholesale price index.
Notes: Q1 2004–Q1 2017 is the estimation period. This is a zoomed in version of Figure 12a.
Of the top 50 BVAR models, we find that 18 models are specified in CPI inflation (either with the
repo rate, or the repo rate and money) and 32 models are specified in WPI inflation (either with the repo
rate, money, or the repo rate and money). Thus, while the CPI inflation specification of monetary policy
prevails in the top 10 models, the WPI inflation specification seems to be a more important predictor of
growth overall. Of note is that in these BVAR models of Indian macroeconomic aggregates, 28 models
are based on the normal-Wishart tight prior, and 22 are based on looser priors (either normal-Wishart or
Minnesota). In terms of the exogenous control variables, the spot oil price index appears in 26 models
alone, and in 12 models with the Federal Funds rate. Over the estimation period starting in 2004, US
monetary policy seems to matter less than oil prices for predicting economic activity in India.
Table 6: Composition of the Top 50 Gross Domestic Product Growth Forecasts

Real Monetary Exogenous Priors

16 GF 14 CPI, REP 26 OIL 28 Norm Tight
12 FEF 4 CPI, M1, REP 12 OIL, FF 11 Norm Loose
10 KD 12 WPI, M1, REP 4 FF 11 Minn Loose
6 EC 11 WPI, M1 8 NONE
6 Mon 9 WPI, REP
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal
funds, GDP = gross domestic product, GF = global factors, KD = Keynesian demand, M1 = narrow
money, Q = quarter, REP = repo rate, WPI = wholesale price index.

An interesting finding is that the GF model of the real side of the economy appears to be
among the better predictors of GDP growth. Sixteen of the top 50 models are based on the GF
specification, with the FEF model coming second with 12 of the top 50 BVAR models. The KD model
comes third followed by the EC model. These findings indicate that FDI and portfolio flows seem to
matter significantly for predicting the dynamics of GDP growth. This seems intuitive given the
significant increase in India’s international financial integration over the past few decades as discussed
in section II. Much of this increase has been driven by a surge in portfolio and FDI flows, which was
aided by India undertaking a graded liberalization of capital flows. Table 6 above provides further
details on the composition of the top 50 BVAR forecasting models.
C. Bayesian Vector Autoregressions: Q1 2011–Q1 2017 Estimation Period
We estimate the 1,680 BVAR models again over the Q1 2012– – Q1 2017 sample to find that the real
sector specifications are similarly ranked in terms of predicting GDP growth, as found in Table 7. The
GF and FEF comprise 15 and 10 models, respectively of the top 50 models. Now, however, the CPI
specification of the inflationary process dominates the top 10 models (all are in the CPI) as well as the
top 50 models (42 are in the CPI and only 8 are in the WPI). Further, 29 of the top 50 models have the
monetary policy specification in CPI inflation, the repo rate, and money. The high predictive power of
this particular model is fairly intuitive since CPI inflation was adopted as the target for monetary policy
in 2015 (whereas WPI inflation had been one of the key variables considered for monetary policy for
much of the 2004–2017 estimation period). Money possibly gains more importance in the shorter
estimation period due to the demonetization shock, which eradicated 86% of the currency in
circulation and was correlated with a sharp drop in economic activity.
We can see that the spot oil price index has lost predictive power in the shorter and more
recent estimation period, and that the Federal Funds rate plays more of a role now. This could be due
to the lower (albeit negative) correlation in recent years between GDP growth and oil prices due to
asymmetric shocks (for instance, GDP growth was adversely affected by the November 2016
demonetization shock whereas oil prices were not). Further, the Fed Funds rate hikes over recent years
could have affected capital flows and economic activity in emerging markets including India. For
instance, in mid-2013, Federal Reserve’s signal about the possibility of tapering its security purchase
had a negative impact on the financial conditions in several emerging markets, including India.
Similarly, the Fed Funds rate hike in Q4 2015 was followed by a sharp drop in portfolio flows to India in
Q1 2016. The normal-Wishart tight prior again dominates and is used in 36 of the top 50 forecasting
models. The detailed forecast evaluation statistics for all 50 BVAR models are found in Table A.3 in
the Appendix.


15 GF 29 CPI, M1, REP 27 FF 36 Norm Tight
10 FEF 12 CPI, REP 23 None 14 Minn Loose
9 KD 1 CPI, M1
14 EC 3 WPI, REP
2 Mon 3 WPI, M1
2 WPI, M1, REP
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows,
FF = Federal funds, GDP = gross domestic product, GF = global factors, KD = Keynesian demand,
M1 = narrow money, Q = quarter, REP = repo rate, WPI = wholesale price index.

Table 8 displays the top 10 BVAR forecasting models with the corresponding forecast
evaluation statistics. Figure 13a (zoomed in further in Figure 13b) shows that the out-of-sample
forecasts generated by these models are somewhat further away from the data than the models
estimated over the 2004–2017 period. This could be due to major structural changes including
inflation targeting and demonetization in the shorter, more recent sample. We tried controlling for
structural breaks in these models, but this did not increase predictive accuracy. Anticipation effects,
especially in advance of the inflation targeting regime, could explain why. While we can learn much
about the predictive nature of these data by looking at the changing dynamics of the forecasting
models over time, the findings suggest that it might be better to estimate the models over a longer
period in light of the structural changes over the past few years.
Table 8: Top 10 Bayesian Vector Autoregression Forecasting Models of

Rank Real Monetary Exo Prior RRMSFE RMAFE Theil U

1 KD3 CPI, M1, REP FF Norm Tight 0.028 0.028 0.016
2 EC4 CPI, M1, REP FF Norm Tight 0.046 0.035 0.024
5 GF2 CPI, M1, REP FF Norm Tight 0.051 0.040 0.026
7 KD3 CPI, REP FF Norm Tight 0.052 0.047 0.026
9 … CPI, M1, REP FF Norm Tight 0.054 0.044 0.028
10 FEF1 CPI, M1, REP FF Norm Tight 0.055 0.044 0.028
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal funds,
GDP = gross domestic product, GF = global factors, KD = Keynesian demand, M1 = narrow money, Q = quarter,
REP = repo rate, RMAFE = root mean absolute forecast error, RRMSFE = relative root mean squared forecast
error.
Figure 13a: Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018)
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external factors, FF = Federal funds, GDP = gross domestic
product, GF = global factors, KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo rate.
Note: Q1 2011–Q1 2017 is the estimation period.
Figure 13b: Dynamic Forecasts of Gross Domestic Product Growth (Q2 2017–Q1 2018):
A Closer Look
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal funds, GDP = gross domestic
product, GF = global factors, KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo rate.
Notes: Q1 2011–Q1 2017 is the estimation period. This is a zoomed in version of Figure 13a.
D. Vector Autoregression and Structural Vector Autoregression Forecasts
It is interesting to compare the predictive ability of the BVAR models with that of unrestricted VARs and
more structured SVARs. VARs impose minimal assumptions on the data and are useful for forecasting
purposes where identification is of secondary concern. A drawback of these models, however, is that of
overparameterization. This results in multicollinearity, leading to inefficient estimates and potentially
large forecast errors. We find that the BVAR forecasts generally outperform the VAR predictions. The
relative forecast statistics of the top 10 BVAR models compared to their corresponding VARs for the two
estimation samples are provided in Tables A.4 and A.5 in the Appendix.
SVARs are alternative forecasting models that impose economic theory to transform the
hitherto unrestricted VAR into a system of structural equations. The SVARs are estimated using
Choleski decomposition, a recursive identification scheme where the error terms in each regression
equation is assumed to be uncorrelated with the error terms in the preceding equation. The
identification schemes discussed in section III generally perform quite well, especially for the longer
estimation sample starting in 2004, with three SVAR models in WPI inflation and two SVAR models in
CPI inflation rivaling the forecasting accuracy of the BVAR models. The SVAR models are detailed in
Table 3 in section III, and their corresponding forecast evaluation statistics are found in Tables A.6 and
A.7 in the Appendix.
E. Extending the Validation Period
The validation period for assessing the predictive ability of the specified models extends over the four
latest quarters for which the macroeconomic data are available. While the four-quarter ahead dynamic
forecasts provide quite a rigorous test of the out-of-sample forecast accuracy of the BVARs, we also
vary the length of the validation period to five and six quarters. Given the nature of the
macroeconomic data and economic policy in India, one potential concern with doing so is that in Q3
2016 there was a surprise demonetization that wiped out a significant amount of the currency from
circulation and was thought to have widespread effects including a large short-term drag on economic
activity. Due to the unexpected and highly impactful nature of the demonetization, beginning the
validation period during and right after the shock in Q3 2016 and Q4 2016 could potentially lead to
large forecast errors. We find, however, that the BVAR models are still able to predict GDP growth
quite well, and the best five- and six-quarter ahead out-of-sample forecasts are provided in Figures 14
and 15 below.
Figure 14: 5-Quarter Ahead Bayesian Vector Figure 15: 6-Quarter Ahead Bayesian Vector
Autoregression Forecast Autoregression Forecast
GDP = gross domestic product, Q = quarter. GDP = gross domestic product, Q = quarter.
Note: 5-Quarter Ahead Forecasts: Q1 2004–Q4 2016 estimation Note: 6-Quarter Ahead Forecasts: Q1 2004–Q3 2016 estimation
period, and Q1 2017–Q1 2018 validation period period, and Q4 2016–Q1 2018 validation period
Source: Authors’ calculations. Source: Authors’ calculations.

F. Inflation Forecasts
While it is not the primary purpose of this study to forecast inflation, we also assess the ability of the
BVAR models in predicting CPI inflation, which is targeted by the RBI. The models are found to predict
inflation dynamics well. A recent study across 14 EMEs (Duncan and Martinez-Garcia 2018) indicates
that ARIMA models of inflation, especially a random walk, generally outperform more sophisticated
models. The structural changes in the data, and often volatile indicators and inflation dynamics in
EMEs can make inflation forecasting challenging. It seems, however, that the BVAR models of GDP
growth in this study also have good predictive ability for inflation.
Table 9 provides the CPI inflation forecast evaluation statistics for the longer estimation
sample beginning in Q1 2004, and Table A.8 in the Appendix does likewise for the estimation sample
beginning in Q1 2011. We look at the inflation forecasts from the top 10 BVAR models as well as
ARIMA models. Estimation of the ARIMA models for inflation proceeds in the same manner as the
ARIMAs for GDP detailed earlier in this section. The best univariate model of inflation has 1 AR term
and 4 MA terms for the estimation period beginning in Q1 2004, and 4 AR terms and 1 MA term for
the estimation period beginning in Q1 2011. The top ARIMA models outperform a random walk model
of inflation. Of particular note is that all the BVAR forecasts outperform the ARIMA models, which is
an interesting finding from the standpoint of the literature and reiterates the relatively high
informational content of quarterly BVAR models in India.
Table 9: Dynamic Bayesian Vector Autoregression and Autoregressive Integrated Moving

Average Forecasts of Consumer Price Index Inflation (Q1 2004–Q1 2017 estimation period)

11 Best ARIMA forecast for inflation (1 AR and 4 MA terms) 0.336 0.305 0.200
AR = autoregression, ARIMA = Autoregressive Integrated Moving Average, CPI = consumer price index, FEF = fiscal external
flows, GF = global factors, KD = Keynesian demand, MA = moving average, Q = quarter, REP = repo rate, RMAFE = root mean
absolute forecast error, RRMSFE = relative root mean squared forecast error.

G. The Changing Dynamics of Gross Domestic Product Growth
The results from the empirical analysis so far suggest that FDI and portfolio flows are among the more
significant variables relevant for predicting recent GDP growth in India. This finding is robust to
changes in the estimation period and to revisions in the national accounts data, and holds true even
after accounting for major shocks and structural changes in the sample including the GFC,
demonetization, and shift toward an inflation targeting regime. It is a matter of interest, however, to
assess whether the dynamics and predictability of GDP growth have changed over time. We therefore
also predict GDP growth in the early 2000s, by setting the estimation period from Q1 2000 to Q4
2006, and the validation period four quarters ahead from that. This forecasting period is right before
the GFC and around the time that exports in India started to grow rapidly due to the opening up of the
economy.
A key finding is that trade linkages have high predictive power for GDP growth in the historical
data. Thirty-five of the top 50 models, as found in Tables 10 and A9, include the 36-currency nominal
or real trade-weighted effective exchange rates. These models are based on the EC theory discussed in
section III, where exchange rate fluctuations impact GDP growth through trade linkages and by
affecting consumption patterns in developing countries that depend on traded goods (e.g., Iyer 2016,
Cravino and Levchenko 2017). The high predictive power of the EC model is corroborated by the early
2000s data, which indicates that exports grew at a startling pace over the historical estimation sample,
almost doubling as a fraction of GDP from 12% in Q1 2000 to over 22% in Q4 2006. Since then,
however, export growth has slowed down, and exports as a fraction of GDP have been under 20% over
the past few years. The slowdown in trade growth since the mid-2000s corresponds to the primary
time period for most of the analysis in this paper and we find that the GF theory works well.
The findings also indicate that CPI inflation is a more relevant predictor for GDP growth than
WPI inflation in the early 2000s. One reason why this might be the case is because the wealth effect
created through the dramatic surge in export income could have eased liquidity constraints. The majority
of households in India operate on a disposable income basis, as they do not have the financial means to
borrow and save. Unlike the effects of a positive wealth shock in developed economies where most
households are able to smooth consumption by hedging against shocks through assets, the positive
wealth shock created by the surge in exports could have led to a significant increase in consumer
spending pushing up CPI inflation (for more details on inflation in the 2000s in India, see Bhattacharya,
Rao, and Sen Gupta 2014). Table 10 summarizes the results of the top 50 BVAR forecasting models, with
the corresponding detailed forecast evaluation statistics found in Table A.9 in the Appendix.

35 EC 6 CPI, REP 17 OIL 18 Norm Tight
8 KD 29 CPI, M1 11 FF 23 Norm Loose
4 GF 7 CPI, M1, REP 22 NONE 9 Minn Loose
3 Mon 4 WPI, M1, REP
4 WPI, REP
CPI = consumer price index, EC = exchange rate consumption, FF = Federal funds,
GF = global factors, KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo
rate, WPI = wholesale price index.
VI. CONCLUSION
This study seeks to forecast GDP growth in India using a BVAR framework. We also specify other time
series econometric models such as VARs, SVARs, and ARIMAs. The models are used to forecast
growth over the four most recent quarters as well as growth earlier in the 2000s. The BVAR models are
based on macroeconomic specifications of the real and monetary sides of the Indian economy. We
take into account the potential role of global factors in influencing growth in India as well as
conventional aggregate demand variables, and control for exogenous variables such as oil prices. Given
the changing nature of monetary policy over time in India, the models further assess alternative
monetary theories that explain the underlying inflationary process in terms of the WPI versus the CPI.
The study estimates over 3000 BVAR models over two main periods that extend until Q1
2017, one longer and tracking back until 2004 and the second one more recent and starting in 2011.
Dynamic forecasts of GDP growth are cast four quarters ahead, and the predictive ability of different
models is compared based on a set of forecast evaluation statistics. We find that the best-performing
BVAR models are able to almost perfectly capture the dynamics of Indian growth, especially over the
longer estimation sample. These models also have good predictive capability for CPI inflation. The
economic theory underlying the BVARs suggests that models that specify the inflationary process in
terms of the CPI, as well as models that include FDI and portfolio flows, have high predictive content
for recent GDP growth. BVAR models that capture trade linkages perform well in the early 2000s. The
results from this study provide suggestive evidence that quarterly BVAR models of Indian growth have
high predictive ability.
APPENDIX
Table A.1: Data Sources
Indicators Source
Gross domestic product (GDP) at market price Ministry of Statistics and Programme Implementation
(MOSPI), Government of India
In 2004–2005 prices: Quarterly data from the first quarter
(Q1) 2005–2006 to Q3 2010–2011
In 2011–2012 prices: Quarterly data from Q4 2010–2011 to
Q1 2018–2019
Government final consumption expenditure MOSPI, Government of India
In 2004–2005 prices: Quarterly data from Q1 2005–2006

to Q3 2010–2011
Q1 2018–2019
Private final government expenditure MOSPI, Government of India

to Q3 2010–2011
Q1 2018–2019
Gross fixed capital formation MOSPI, Government of India

to Q3 2010–2011
Q1 2018–2019
Exports of goods and services MOSPI, Government of India

to Q3 2010–2011
Q1 2018–2019
Imports of goods and services MOSPI, Government of India

to Q3 2010–2011
Q1 2018–2019
Trade balance Directorate General of Commercial Intelligence and
Statistics
Trade balance as a percent of GDP Reserve Bank of India (RBI); Quarterly Estimates of GDP,
MOSPI
Current account as a percent of GDP RBI; Quarterly Estimates of GDP, MOSPI

Foreign direct investment as a Percent of GDP RBI; Quarterly Estimates of GDP, MOSPI
continued on next page
Appendix | 29
Table A.1 continued
Indicators Source
Foreign portfolio investment as a percent of GDP RBI; Quarterly Estimates of GDP, MOSPI
Consumer price index: Industrial workers: (General index): RBI: Handbook of Statistics on Indian Economy, Table 166
2001=100
Consumer price index (Combined): 2012=100 RBI: Database on Indian Economy

Wholesale price index: 2011–2012=100 RBI: Database on Indian Economy
Index of industrial production: 2011–2012=100 RBI: Database on Indian Economy
Narrow money (M1) RBI: Handbook of Statistics on Indian Economy,
Components of Money Supply, Table 168
Broad money (M3) RBI: Handbook of Statistics on Indian Economy,

Components of Money Supply, Table 168
Repo RBI: Weekly Statistical Supplement, Table 5

Reverse repo RBI: Weekly Statistical Supplement, Table 5
Nominal effective exchange rate RBI: Handbook of Statistics on Indian Economy, External
Sector, Table 204
Real effective exchange rate RBI: Handbook of Statistics on Indian Economy, External
Sector, Table 204
Spot crude oil prices Federal Reserve Economic Database (FRED), Federal
Reserve Bank of St. Louis
Federal funds rate FRED, Federal Reserve Bank of St. Louis

30 | Appendix
Table A.2: Top 50 Bayesian Vector Autoregression Forecasting Models of


8 FEF1 WPI, REP OILS, FF Minn Loose 0.013 0.011 0.007
11 GF3 WPI, M1 OILS Norm Tight 0.014 0.012 0.007
12 GF2 WPI, M1, REP OILS Norm Tight 0.014 0.013 0.007
15 … WPI, M1, REP OILS Norm Tight 0.014 0.012 0.007
18 … WPI, M1 OILS Norm Tight 0.015 0.012 0.007
21 GF1 WPI, REP OILS, FF Norm Loose 0.015 0.012 0.008
22 GF1 WPI, REP FF Minn Loose 0.015 0.013 0.008
25 FEF1 WPI, REP OILS, FF Norm Loose 0.015 0.012 0.008
29 GF3 WPI, M1 OILS, FF Minn Loose 0.017 0.015 0.009
30 FEF3 WPI, REP FF Norm Loose 0.017 0.015 0.009
31 KD3 CPI, M1, REP OILS Norm Tight 0.017 0.014 0.009
32 GF1 WPI, M1 OILS + FF Minn Loose 0.018 0.014 0.009
33 FEF1 WPI, M1, REP OILS Norm Tight 0.018 0.016 0.009
35 … WPI, REP FF Minn Loose 0.018 0.017 0.009
Appendix | 31
Table A.2 continued

37 EC3 WPI, M1, REP … Norm Loose 0.018 0.015 0.009
38 EC1 WPI, M1, REP … Norm Loose 0.018 0.017 0.009
39 GF3 WPI, REP FF Minn Loose 0.018 0.017 0.009
40 FEF3 WPI, M1 OILS Norm Tight 0.019 0.018 0.009
41 GF1 CPI, M1, REP OILS Minn Loose 0.019 0.016 0.009
46 KD4 CPI, M1, REP OILS, FF Norm Tight 0.020 0.018 0.010
47 … WPI, REP OILS, FF Norm Loose 0.020 0.016 0.010
48 GF3 WPI, REP OILS, FF Norm Loose 0.020 0.016 0.010
49 KD3 CPI, M1, REP OILS, FF Norm Tight 0.020 0.018 0.010
50 … WPI, M1, REP OILS, FF Norm Tight 0.021 0.015 0.010
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal funds, GF = global factors,
KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo rate, RMAFE = root mean absolute forecast error, RRMSFE
= relative root mean squared forecast error, WPI = wholesale price index.


11 KD3 CPI, M1, REP … Norm Tight 0.055 0.049 0.028
12 EC1 WPI, REP … Minn Loose 0.055 0.041 0.028
14 EC1 WPI, M1 … Minn Loose 0.056 0.042 0.029
15 EC3 WPI, REP … Minn Loose 0.058 0.042 0.030
16 FEF2 CPI, M1, REP FF Minn Loose 0.058 0.054 0.029
32 | Appendix
Table A.3 continued

17 KD3 CPI, M1 FF Norm Tight 0.058 0.046 0.030
WPI, M1,
18 EC1 REP … Minn Loose 0.059 0.043 0.030
19 EC3 WPI, M1 … Minn Loose 0.059 0.042 0.030
20 KD1 CPI, M1, REP FF Minn Loose 0.059 0.051 0.029
22 GF3 CPI, M1, REP FF Minn Loose 0.059 0.053 0.029
23 KD3 CPI, REP … Norm Tight 0.059 0.054 0.030
24 FEF1 CPI, REP … Norm Tight 0.059 0.054 0.030
25 GF2 CPI, M1, REP … Norm Tight 0.060 0.048 0.030
26 FEF3 CPI, REP … Norm Tight 0.060 0.053 0.030
27 GF3 CPI, REP … Norm Tight 0.060 0.055 0.031
28 FEF1 CPI, M1, REP … Norm Tight 0.061 0.053 0.031
30 EC3 CPI, M1, REP … Norm Tight 0.061 0.052 0.031
32 FEF2 CPI, M1, REP … Norm Tight 0.061 0.046 0.031
33 GF1 CPI, REP … Norm Tight 0.061 0.056 0.031
34 FEF3 CPI, M1, REP FF Minn Loose 0.061 0.057 0.030
35 EC4 CPI, M1, REP … Norm Tight 0.061 0.053 0.031
36 KD1 CPI, M1, REP … Norm Tight 0.062 0.048 0.031
37 CE3 WPI, REP … Norm Tight 0.062 0.057 0.032
WPI, M1,
38 CE3 REP … Minn Loose 0.062 0.044 0.032
39 GF2 CPI, M1, REP FF Minn Loose 0.062 0.054 0.031
40 EC4 CPI, M1, REP FF Minn Loose 0.063 0.054 0.031
41 EC3 CPI, M1, REP FF Minn Loose 0.063 0.054 0.031
42 … CPI, M1, REP … Norm Tight 0.063 0.055 0.032
43 EC3 WPI, M1 … Norm Tight 0.063 0.059 0.033
44 GF3 CPI, REP FF Norm Tight 0.063 0.057 0.032
45 FEF1 CPI, REP FF Norm Tight 0.063 0.058 0.032
46 KD3 CPI, M1, REP FF Minn Loose 0.063 0.054 0.031
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal funds, GF = global factors,
KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo rate, RMAFE = root mean absolute forecast error, RRMSFE
= relative root mean squared forecast error, WPI = wholesale price index.
Appendix | 33
Table A.4: Top 10 Vector Autoregression Forecasting Models of

Rank Real Monetary Exo RRMSFE (RW) RRMSFE (VAR)

1 GF2 CPI, REP OILS 0.011 0.782
2 FEF2 CPI, REP OILS 0.011 0.791
3 KD4 CPI, REP OILS 0.011 0.517
4 … CPI, REP OILS 0.012 1.015
5 KD4 CPI, REP … 0.013 0.820
6 FEF3 CPI, REP OILS 0.013 1.062
7 EC3 WPI, M1 … 0.013 0.220
8 FEF1 WPI, REP OILS, FF 0.013 0.467
9 GF3 CPI, REP OILS 0.014 1.021
10 EC1 WPI, M1, REP OILS, FF 0.014 0.206
CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external flows, FF = Federal funds, GF = global
factors, KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo rate, RRMSFE = relative root mean squared
forecast error, RW = random walk, VAR = vector autoregression, WPI = wholesale price index.
Note: The root mean squared forecast error of each Bayesian vector autoregression is provided relative to the root mean
squared forecast error of its corresponding vector autoregression in the last column.
Table A.5: Top 10 Vector Autoregression Forecasting Models of

Rank Real Monetary Exo RRMSFE (RW) RRMSFE (VAR)

1 KD3 CPI, M1, REP FF 0.554 0.032
2 EC4 CPI, M1, REP FF 0.951 0.046
3 EC3 CPI, M1, REP FF 1.017 0.047
4 KD1 CPI, M1, REP FF 1.083 0.049
5 GF2 CPI, M1, REP FF 1.029 0.051
6 GF3 CPI, M1, REP FF 1.052 0.051
7 KD3 CPI, REP FF 0.713 0.052
8 GF1 CPI, M1, REP FF 0.911 0.053
9 … CPI, M1, REP FF 0.921 0.054
10 FEF1 CPI, M1, REP FF 0.994 0.055
BVAR = Bayesian vector autoregression, CPI = consumer price index, EC = exchange rate consumption, FEF = fiscal external
flows, FF = Federal funds, GF = global factors, KD = Keynesian demand, M1 = narrow money, Q = quarter, REP = repo rate,
RRMSFE = relative root mean squared forecast error, RW = random walk, VAR = vector autoregression.
Note: The root mean squared forecast error of each Bayesian vector autoregression is provided relative to the root mean
squared forecast error of its corresponding vector autoregression in the last column.
34 | Appendix
Table A.6: Structural Vector Autoregression Forecasting Models of

Recursive Identification Scheme RRMFSE RMAFE Theil U
WPI, GDP, M1, REP 0.012 0.011 0.156471
WPI, GDP, M1, REP, [Ex: FF] 0.015 0.011 0.200434
CPI, GDP, M1, REP 0.017 0.012 0.222417
CPI, GDP, M1, REP, [Ex: FF] 0.019 0.016 0.252242
WPI, GDP, REP 0.020 0.017 0.240134
CPI, GDP, REP 0.026 0.024 0.318946
CPI, GDP, M1, REP, [Ex: OIL, FF] 0.032 0.030 0.309989
CPI, GDP, M1, REP, [Ex: OIL] 0.035 0.030 0.416284
CPI, GDP, REP, [Ex: FF] 0.047 0.042 0.581248
WPI, GDP, REP, [Ex: FF] 0.053 0.050 0.617851
WPI, GDP, M1, REP, [Ex: OIL, FF] 0.056 0.055 0.676907
WPI, GDP, M1, REP, [Ex: OIL] 0.067 0.063 0.767888
CPI, GDP, REP, [Ex: OIL] 0.071 0.070 0.839579
WPI, GDP, REP, [Ex: OIL] 0.092 0.091 1.103821
CPI, GDP, REP, [Ex: OIL, FF] 0.092 0.090 1.123632
WPI, GDP, REP, [Ex: OIL, FF] 0.096 0.096 1.137237
CPI = consumer price index, FF = Federal funds, GDP = gross domestic product, M1 = narrow money, Q = quarter, REP =
repo rate, RMAFE = root mean absolute forecast error, RRMSFE = relative root mean squared forecast error, WPI =
wholesale price index.
Note: Structural vector autoregression identification scheme details are discussed in section III and summarized in Table 3.
Table A.7: Structural Vector Autoregression Forecasting Models of

Identification Scheme RRMFSE RMAFE Theil U
WPI, GDP, M1, REP 0.059 0.049 0.029
WPI, GDP, M1, REP, [Ex: FF] 0.074 0.065 0.037
CPI, GDP, M1, REP 0.075 0.066 0.037
CPI, GDP, M1, REP, [Ex: FF] 0.078 0.069 0.039
WPI, GDP, REP 0.093 0.081 0.047
CPI, GDP, REP 0.107 0.091 0.055
CPI, GDP, M1, REP, [Ex: OIL, FF] 0.110 0.092 0.056
CPI, GDP, M1, REP, [Ex: OIL] 0.110 0.090 0.057
CPI, GDP, REP, [Ex: FF] 0.122 0.097 0.063
WPI, GDP, REP, [Ex: FF] 0.124 0.099 0.064
WPI, GDP, M1, REP, [Ex: OIL, FF] 0.137 0.119 0.072
WPI, GDP, M1, REP, [Ex: OIL] 0.154 0.129 0.082
CPI, GDP, REP, [Ex: OIL] 0.156 0.131 0.082
WPI, GDP, REP, [Ex: OIL] 0.156 0.128 0.083
CPI, GDP, REP, [Ex: OIL, FF] 0.171 0.147 0.090
WPI, GDP, REP, [Ex: OIL, FF] 0.176 0.152 0.094
CPI = consumer price index, FF = Federal funds, GDP = gross domestic product, M1 = narrow money, Q = quarter, REP =
repo rate, RMAFE = root mean absolute forecast error, RRMSFE = relative root mean squared forecast error, WPI =
wholesale price index.
Note: Structural vector autoregression identification scheme details are discussed in section III and summarized in Table 3.
Appendix | 35
Table A.8: Dynamic Bayesian Vector Autoregression and Autoregressive Integrated Moving
Average Forecasts of Consumer Price Index Inflation (Q1 2011–Q1 2017 estimation period)

11 Best ARIMA forecast of inflation (4 AR and 1 MA terms) 0.910 0.865 0.200
AR = autoregression, ARIMA = autoregressive integrated moving average, CPI = consumer price index, FF = Federal funds,
M1 = narrow money, MA = moving average, Q = quarter, REP = repo rate, RMAFE = root mean absolute forecast error, RRMSFE =
relative root mean squared forecast error.

Rank Real Monetary Exo Prior RRMSFE RMSFE Theil U

1 EC2 CPI, M1 OILS Minn Loose 0.071 0.068 0.035
2 EC2 CPI, M1, REP OILS Norm Tight 0.072 0.066 0.036
3 EC3 WPI, M1, REP FF Norm Loose 0.073 0.067 0.037
4 EC4 CPI, M1 OILS Norm Loose 0.073 0.067 0.036
5 EC4 CPI, M1 OILS Norm Tight 0.074 0.066 0.037
6 EC2 CPI, M1 … Minn Loose 0.075 0.070 0.038
7 EC4 WPI, M1, REP FF Norm Tight 0.075 0.065 0.038
8 EC4 CPI, M1, REP OILS Norm Loose 0.075 0.065 0.038
9 EC2 CPI, M1, REP OILS Norm Loose 0.076 0.074 0.038
10 EC4 CPI, M1 FF Norm Loose 0.077 0.066 0.039
11 KD CPI, M1 … Norm Loose 0.078 0.072 0.039
12 EC1 CPI, M1 … Norm Tight 0.079 0.077 0.040
14 EC1 CPI, M1 … Norm Loose 0.079 0.078 0.039
16 … CPI, M1 OILS Norm Loose 0.079 0.074 0.040
17 EC2 CPI, M1 FF Norm Loose 0.079 0.061 0.040
36 | Appendix
Table A.9 continued
Rank Real Monetary Exo Prior RRMSFE RMSFE Theil U

20 GF2 WPI, REP OILS Norm Loose 0.080 0.070 0.040
21 KD1 CPI, M1 … Norm Loose 0.080 0.076 0.040
22 EC3 CPI, M1, REP OILS Norm Tight 0.080 0.068 0.040
23 GF2 WPI, REP OILS Norm Tight 0.080 0.072 0.040
25 KD1 CPI, M1 FF Norm Loose 0.080 0.068 0.041
27 KD4 CPI, M1 … Norm Loose 0.080 0.071 0.041
28 EC2 CPI, REP OILS Minn Loose 0.080 0.068 0.040
29 EC4 CPI, M1, REP … Minn Loose 0.081 0.079 0.041
32 EC4 CPI, REP FF Norm Loose 0.081 0.078 0.041
33 EC4 CPI, M1, REP … Norm Loose 0.081 0.079 0.040
35 EC4 CPI, M1 OILS Minn Loose 0.081 0.069 0.042
37 KD2 CPI, M1 FF Norm Loose 0.082 0.067 0.042
38 KD2 CPI, M1 … Norm Tight 0.082 0.069 0.042
39 KD1 CPI, M1 … Norm Tight 0.082 0.074 0.042
41 GF2 WPI, REP … Norm Loose 0.082 0.082 0.041
43 EC2 CPI, REP FF Norm Tight 0.082 0.074 0.042
44 EC2 CPI, M1, REP … Norm Loose 0.082 0.079 0.041
46 GF2 WPI, REP … Minn Loose 0.083 0.080 0.042
47 … CPI, M1 … Norm Loose 0.083 0.082 0.042
49 EC4 CPI, REP FF Norm Tight 0.083 0.083 0.042
CPI = consumer price index, EC = exchange rate consumption, FF = Federal funds, GF = global factors, KD = Keynesian demand,
M1 = narrow money, Q = quarter, REP = repo rate, RMSFE = root mean squared forecast error, RRMSFE = relative root mean
squared forecast error, WPI = wholesale price index.

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Quarterly Forecasting Model for India’s Economic Growth:
Bayesian Vector Autoregression Approach
This paper presents a framework for forecasting India’s gross domestic product (GDP) growth on a quarterly
basis. The framework, based on Bayesian econometric methods, is found to have high predictive ability. Useful
findings emerge on the particular variables that are responsible for explaining GDP growth in India. The best-
performing models take into account the influence of capital flows in driving growth over the past decade and
trade linkages in influencing growth in the early 2000s. Overall, the results from this study provide suggestive
evidence that Bayesian vector autoregression methods are highly effective in predicting GDP growth in India.
About the Asian Development Bank
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QUARTERLY FORECASTING MODEL

FOR INDIA’S ECONOMIC GROWTH:

NO. 573 ADB ECONOMICS

ASIAN DEVELOPMENT BANK

Quarterly Forecasting Model for India's Economic Growth:

The authors would like to gratefully acknowledge the

ASIAN DEVELOPMENT BANK

© 2019 Asian Development Bank

Some rights reserved. Published in 2019.

ISSN 2313-6537 (print), 2313-6545 (electronic)

Corrigenda to ADB publications may be found at http://www.adb.org/publications/corrigenda.

TABLES AND FIGURES iv

II. MACROECONOMIC TRENDS IN INDIA 4

1 Real Sector Groups in the Bayesian Vector Autoregressions 13

1 Gross Domestic Product Growth 5

JEL codes: C11, C32, C53, F43

We construct a quarterly forecasting framework employing key macroeconomic variables

II. MACROECONOMIC TRENDS IN INDIA

Figure 1: Gross Domestic Product Growth

Figure 2: Decomposition of Gross Domestic Product Growth

Figure 3: Growth Rate of Key Components of Gross Domestic Product

GDP = gross domestic product, Q = quarter.

Figure 4: dƌĂĚĞ/ŶƚĞŐƌĂƟŽŶ Figure 5: ǆƉŽƌƚĂŶĚ/ŵƉŽƌƚ'ƌŽǁƚŚ

GDP = gross domestic product. Q = quarter.

FDI = foreign direct investment, GDP = gross domestic product.

Figure 11: Effective Exchange Rates

ܻ௧ ൌ ߤ ൅ ߚଵ ܻ௧ିଵ ൅ ‫ ڮ‬൅ ߚ௞ ܻ௧ି௞ ൅ ‫ݑ‬௧

Consider the following conditional prior distribution of the VAR coefficients

ߚȁߑǡ ‫̱ݕ‬ሺߚመ ሺߦሻǡ ܸ෠ ሺߦሻ

ߚመ ሺߣሻ ‫ܿ݁ݒ ؠ‬ሺ‫ܤ‬෠ሺߦሻሻ

‫ܤ‬෠ሺߦሻ ‫ ؠ‬ሺܺ ᇱ ܺ ൅ ሺߗߦሻିଵ ሻିଵ ሺܺ ᇱ ܻ ൅ ሺߗߣሻିଵ ߭ሻ

ܸ෠ ሺߦሻ ‫۪ߑ ؠ‬ሺܺ ᇱ ܺ ൅ ሺߗߣሻିଵ ሻିଵ

The Minnesota prior on ߚ is normally distributed conditional on the variance–covariance

A. Real and Monetary Variables

corresponding fluctuations in international relative prices in open economies, it is interesting to test

Table 1: Real Sector Groups in the Bayesian Vector Autoregressions

Real Sector Groups Variables

Table 2: Monetary Sector Groups in the Bayesian Vector Autoregressions

Inﬂationary Process Variables

B. Structural Vector Autoregressions

Table 3: Structural Vector Autoregression Models

Model 1 {cpi_inf, gdp, m1, rep}

Table 4: Empirical Models

Real Variables Monetary Variables

A. Univariate Autoregressive Integrated Moving Average Models

B. Bayesian Vector Autoregressions: Q1 2004–Q1 2017 Estimation Period

Table 5: Top 10 Bayesian Vector Autoregression Forecasting Models of

Rank Real Monetary Exo Prior RRMFSE RMAFE Theil U

Table 6: Composition of the Top 50 Gross Domestic Product Growth Forecasts

Real Monetary Exogenous Priors

C. Bayesian Vector Autoregressions: Q1 2011–Q1 2017 Estimation Period

Table 7: Composition of the Top 50 Gross Domestic Product Growth Forecasts

Real Monetary Exogenous Priors

Table 8: Top 10 Bayesian Vector Autoregression Forecasting Models of

Rank Real Monetary Exo Prior RRMSFE RMAFE Theil U

D. Vector Autoregression and Structural Vector Autoregression Forecasts

E. Extending the Validation Period

Table 9: Dynamic Bayesian Vector Autoregression and Autoregressive Integrated Moving

Rank Real Monetary Exo Prior RRMSFE RMAFE Theil U

Real Monetary Exogenous Priors

Table A.1: Data Sources

In 2004–2005 prices: Quarterly data from Q1 2005–2006

In 2004–2005 prices: Quarterly data from Q1 2005–2006

In 2004–2005 prices: Quarterly data from Q1 2005–2006

Figure 4: dƌĂĚĞ/ŶƚĞŐƌĂƟŽŶ Figure 5: ǆƉŽƌƚĂŶĚ/ŵƉŽƌƚ'ƌŽǁƚŚ

ߚȁߑǡ ‫̱ݕ‬ሺߚመ ሺߦሻǡ ܸ෠ ሺߦሻ